The Dark Side of Wall Street, Part 2

“Make no mistake about it, you are engaged in a brutal zero-sum contest with the financial industry — every penny of commissions, fees, and transactional cost they extract is irretrievably lost to you.” – William Bernstein.

Yesterday’s post was about Wall Street’s habit of designing complex financial products that are difficult to understand. They promise high returns with less risk, but often fail to deliver.  They entail high fees, which are profitable for the producer of these instruments, but not for investors.

It is well worth delving into the issue of brokers’ conflicts of interest.  Your success as an investor depends on knowing how Wall Street really works and in not accepting the client-friendly face it portrays on TV.

William Bernstein, the author of The Four Pillars of Investing, has a lot to say about the competency and compensation of brokers in a chapter called Your Broker is not Your Buddy.

There are no educational requirements for brokers (or, as they’re known in the business, registered reps).  No mandatory courses in finance, economics, law, or even a high-school diploma are necessary to enter the field.  Simply pass the pathetically simple Series 7 exam, and you’re on your way to a profitable career.

It is a sad fact that you can pass the Series 7 exam and begin to manage other people’s accumulated life savings faster than you can get a manicurist’s license in most states.

The most shocking aspect of the brokerage business is that brokers almost never actually calculate the investment results of their clients, let alone reflect on methods for improving them.

Brokers are not trained by the brokerage houses to invest – they are trained to sell.

Brokers pay almost no attention to the returns their clients earn.  It is rare to come across one who routinely calculates his clients’ annual returns, let alone considers what these data might mean.

Brokers do undergo rigorous training, sometimes lasting months – in sales techniques.

What do brokers think about almost every minute of the day? Selling. Selling. And Selling.

Because if they do not sell, they’re on the next train home to Peoria.  The focus on sales breeds a curious kind of ethical anesthesia.  Like all human beings placed in morally dubious positions, brokers are capable of rationalizing the damage to their clients’ portfolios in a multitude of ways.  They provide valuable advice and discipline.  They are able to beat the market.  They provide moral comfort and personal advice during difficult times in the market.  Anything but face the awful truth: that their clients would be far better off without them.  This is not to say that honest brokers who can understand and manage the conflicts of interest inherent in the job do not exist.  But in my experience, they are few and far between.  After all, what is best for the client is to keep investment costs and turnover as low as possible, which also minimizes a broker’s income.

Brokers will protest that in order to keep their clients for the long haul, they must do right by them.  This is much less than half true.  It’s a sad fact that in one year a broker can make more money exploiting a client than in ten years of treating them honestly.  The temptation to take the wrong road is more than most can resist.

Conclusion

Under no circumstances should you have anything to do with a “full service” brokerage firm.

You do not want anyone near your money – advisor or broker – whose compensation is tied in any way to his choice of investment vehicles. 

To be continued.